2/25/2010 @ 11:00AM

Why Bargain Trades Are No Bargain

Discount brokerage Charles Schwab & Co. in early January cut equity trading commissions for all of its $7.7 million retail brokerage clients. Henceforth, even the lowliest investor is entitled to put in a buy or sell order online for U.S. stocks for a mere $9 per trade.

Not to be outdone, Fidelity Investments undercut
Schwab
a few weeks later by slashing its commission to $8 per trade. E-Trade responded shortly afterward with $8 trades for high-volume customers and $10 ones for everyone else.

From the looks of it, discount brokers are engaging in a price war in which the biggest beneficiaries are consumers. Look under the hood, however, and you’ll discover that commissions are one of the last things a serious long-term investor should think about.

Why, then, are brokerages spending so lavishly to advertise them? Because in the brokerage business asset-gathering is nine-tenths of the game, and discount commissions are a highly effective way to gather them.
McDonald’s
does the same thing: It lures you into its restaurants with cheap burgers, but you end up walking out with a Coke and fries as well. With the brokerages, once you’ve signed up there are mutual funds, ETFs, money market and margin accounts, credit cards, bank accounts and other lucrative products to pitch.

It’s also fair to say that cheap commissions are to long-term investing what fast food is to a healthy diet–a temptation you’d best indulge in only rarely. Value investing guru Benjamin Graham once said that each investor’s biggest problem is himself. By dangling cheap trades in front of investors, brokerages are encouraging them to trade often and, more likely than not, hurt their own finances in the process.

Investors who traded frequently and turned over their portfolios an average of 2.5 times a year earned average annual returns of 11.4% during a five-year period in the 1990s, according to a study by finance professors Terrance Odean of the business school at UC, Berkeley and Brad M. Barber of the B-school at UC, Davis. That sounds pretty good until you discover that buy-and-hold investors, averaging an annual turnover of 0.75 times, earned 17.4% per year during the same period.

That’s before taking taxes into account. Smart investors sell their losers to get capital-loss deductions. Dumb ones take short-term gains, taxed at maximum rates, while sitting on their losing positions out of an aversion to admitting mistakes.

“If investors make the same trades they would have otherwise made, lower commissions are clearly better,” says Odean. “The concern is when lower commissions lead them to trade more actively, resulting in poor performance.”

Another problem with focusing on bargain-basement commissions is that they take investors’ eyes off the more important matter of bid/ask spreads and annual expenses for products like mutual funds and ETFs. The Vanguard Total Stock Market ETF costs you $90 annually on a $100,000 position, while the iShares Russell 3000 ETF costs $210 a year.

If you trade with borrowed money, it’s also important to consider the interest rate you’ll pay. On a debit balance of $50,000, Charles Schwab charges 7%, Fidelity 7.075% and
TD Ameritrade
7.25%. (See table below.)
Morgan Stanley
won’t even say what it charges.

In the end cheap trades may drum up some revenue for the brokerage industry, but that’s unlikely to solve a more deeply rooted problem: Brokerages aren’t much trusted by their clients. According to a January report by
Forrester Research
, more than half of customers at all the brokerages studied believe the firms are more interested in making a buck for themselves than in looking out for their clients. It would take more than a buck off a commission to change that perception.

HIGH MARGIN

For infrequent traders, low-cost trades hardly matter. For frequent traders the profits brokers make on the spread between $100,000 in uninvested cash and an equal-size margin loan matter more.